Thesis

Altria (MO) is looking at several potential moves in the M&A arena. The company seeks to take an equity stake in JUUL Labs, and on top of that Altria has been talking to several cannabis companies.

In both cases, there is a good rationale for both Altria and the respective target to work together, which means that a deal is relatively likely. Among the cannabis companies that Altria has looked at, Cronos (CRON) looks like the most attractive target, compared to Aphria (APHA) and Tilray (TLRY), which seem less attractive for Altria.

Planned expansion in the vaping industry (via JUUL Labs) and/or the cannabis space shows that Altria is staying on top of current trends, and management is trying its best to position the company well for the future.

Altria’s expansion plans via JUUL Labs

The e-cigarette/vaping industry is not as large as the traditional cigarette industry by far, but this is nevertheless an attractive market, due to strong market growth rates. E-cigarettes and vaping devices are primarily used by younger adults. Getting such a customer means that the respective tobacco company can sell its products to this customer for many decades.

This is why many tobacco companies have moved into this industry over the last couple of years. Altria has the MarkTen system on the market; other tobacco companies have their own systems. On top of that Altria seeks to introduce heat-not-burn system iQOS to the US market in the foreseeable future. iQOS was developed by Philip Morris (PM) and will be licensed by Altria once the system is approved by the FDA. iQOS has been successfully introduced into markets such as Japan and South Korea already, and has had a positive impact on Philip Morris’ sales performance:

PM Revenue (TTM) data by YCharts

iQOS has allowed for a reversal of the revenue declines that Philip Morris has suffered from during the last five years. Altria seeks to benefit from the R&D efforts that Philip Morris has endured by bringing the device to the US market.

But so far iQOS has not been approved yet, and the US vaping market is currently dominated by a new player in the industry — JUUL Labs. JUUL Labs was created in 2017, its former parent company was founded in 2007. JUUL Labs’ JUUL e-cigarette has turned into the dominant market leader over the last couple of quarters:

Source: cnbc.com

The company now owns more than two-thirds of the entire US e-cigarette market, and JUUL Labs reports a massive sales growth rate. On top of that JUUL Labs has been able to create a well-renowned and beloved brand; the term “juuling” has even turned into a verb describing the act of using an e-cigarette.

The immense growth rate, the market leadership, and the fact that JUUL has become a well-known brand make JUUL Labs attractive as a takeover target. Altria has been in talks with JUUL Labs to acquire a significant minority stake in the e-cigarette company. JUUL Labs has recently been valued at $15 billion, thus Altria would likely have to pay around ~$5 billion for a 30% stake (the exact size of the stake that Altria wants to acquire is not yet known).

There is a rationale for both companies to engage in such a deal. JUUL Labs would benefit from cooperation with Altria through Altria’s vast sales networks, its advertising experience, and Altria’s deep knowledge of the legal framework. Altria has operated in the litigation-prone tobacco industry very successfully for many decades, the company thus knows what is important regarding cooperating with regulators such as the FDA. JUUL Labs, which is a relatively young company without a lot of experience, would profit from Altria’s knowledge, marketing power, and established sales channels.

Altria, on the other hand, would profit from cooperation by acquiring the market leader in the fast-growing e-cigarette industry as well. JUUL produces strong growth rates, and it would give Altria an in into the attractive market. Especially the access to younger smokers, to which Altria could sell products over several decades, makes JUUL Labs a good fit for Altria.

Due to the fact that cooperation or an acquisition would be beneficial for both companies, and due to the fact that both parties seem to be interested, I believe that it is likely that the two will combine in some way over the coming quarters.

Altria’s move into cannabis: Which is the best target?

On top of seeking to expand in the e-cigarette industry, Altria is also interested in becoming a player in the cannabis industry. Due to the legalization of recreational marijuana in Canada, the cannabis industry has gotten a lot of attention over the last couple of quarters. Altria is looking at ways to enter this market, the company is apparently in talks with 3 Canadian cannabis companies: Tilray, Cronos, and Aphria.

TLRY Market Cap data by YCharts

Tilray is by far the biggest company of these three. With a market capitalization of close to $10 billion, Tilray would likely be hard to swallow completely, especially when we factor in a takeover premium and the fact that Altria will likely also spend several billion on a stake in JUUL Labs. The other two companies, valued at $1.3 billion and $1.8 billion, seem like more realistic targets for Altria – Altria could likely take one of these out in an all-cash deal, even on top of acquiring a stake in JUUL Labs.

TLRY Revenue (TTM) data by YCharts

When we look at past results of these companies, we see that Aphria has generated the highest sales so far, slightly leading Tilray (which trades at roughly 7 times Aphria’s valuation). Due to the fact that recreational marijuana sales in Canada are not visible in past results yet, these numbers are not very representative of what revenues these cannabis companies will generate in the future, though.

In Aphria’s case, there is another problem: Short-sellers suggest that the company is engaged in insider-trading and market manipulation, and it seems that there were accounting issues in the past. It is not yet known whether these claims (by short-seller Quintessential Capital Management) are true, but it seems prudent to stay on the sidelines until all facts are known. I thus believe that Aphria will likely not get taken over by Altria, even though Altria was interested in the past (talks between the two companies were first reported in October).

Among the companies Altria has talked to, Tilray and Cronos would be left. Tilray is the vastly more expensive one, both in terms of absolute market capitalization, as well as relative to the revenues the companies will likely produce going forward.

Cronos has estimated that it will be able to produce around 47,000 kg of marijuana in 2019, whereas Tilray expects to grow around 115,000kg during 2019 (the midpoint of year-end 2018 target of 80,000 kg and year-end 2019 target of 150,000 kg, for capacity in both cases). Tilray thus has about 2.5 times the size and scale of Cronos regarding production capacity, yet Tilray is valued at 5.2 times Cronos’ market capitalization right now.

Apart from the fact that a takeover of Tilray seems unlikely due to the fact that financing such a deal would not be easy for Altria, Tilray also seems like the significantly less attractive target due to its much higher valuation (relative to production capacity). Cronos thus looks like the best fit for Altria among these three companies, and Cronos apparently is the company that Altria is most interested in.

A takeover of Cronos could turn out to be beneficial for both Cronos and Altria: Altria would get an entry into the cannabis market, which would become especially interesting once/if cannabis gets legalized in the US. Cronos, on the other hand, would benefit from Altria’s sales experience and Altria’s deep pockets that would allow for ongoing expansion of Cronos’ production capacity.

Financing these deals would not be a problem for Altria

When there are rumors about takeovers, one question that needs to be asked is how the acquirer plans to finance these acquisitions. In Altria’s case that will not be a problem:

Source: Altria 10-Q filing

Altria has generated free cash flows of $6.4 billion during the last three quarters, which equates to annual free cash flows of 8.5 billion. The company pays out $6 billion a year in dividends, which leaves $2.5 billion a year for other purposes, such as takeovers. Altria has $2.4 billion in cash on its balance sheet right now, which could be used for takeovers as well.

If Altria would purchase a $5 billion stake (~30% of the company) in JUUL Labs, and take out Cronos completely (at $2.5 billion, a 35% premium over the current price), the company would spend $7.5 billion on these two acquisitions. Using $2 billion of its cash balance, Altria would thus have to finance about $5.5 billion through the issuance of debt, or about 2 years worth of after-dividend cash flows.

MO EBITDA (TTM) data by YCharts

Altria’s debt totals $14 billion right now, which is just 1.3 times Altria’s annual EBITDA. Increasing the debt level by $5.5 billion to finance the takeovers of JUUL Labs and Cronos would likely not be a problem at all; Altria’s debt to EBITDA ratio would still be relatively low at 1.8 after these two deals.

Final thoughts

Altria is a major tobacco player, but management is always on the hunt for new opportunities to diversify and grow the revenue base. Altria is interested in JUUL Labs and seeks to enter the cannabis market on top of that.

There is a strategic rationale for both deals, and both Altria, as well as the respective takeover target, would benefit from a combination. I believe that Cronos is the most suitable and most likely takeover target in the cannabis space for Altria.

I regard a (possible) takeover of Cronos and a (possible) stake in JUUL Labs as positive for Altria. Financing one or both of these deals would in all likelihood not be a problem for the company – its balance sheet is pretty strong, increasing the leverage slightly will not be a major headwind.

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Disclosure:I am/we are long MO, PM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.